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Tax Prep, Tax Planning and Financial Planning, is there really a difference?

Tax Prep, Tax Planning and Financial Planning, is there really a difference?

September 28, 2023

The short answer is yes, very big differences.

Tax prep, or more commonly known as tax return preparation is usually more of a compliance function.

You report the income earned and the allowable deductions against that income on a tax return and calculate the tax you owe on that taxable income.  Then subtract the tax you paid in during the year and arrive at whether you owe more tax or get a refund of over paid taxes.

But basically it’s a historical exercise.  You are reporting what happened last year, not what is happening this year or future years.

Kind of like looking in the rear view mirror when you are driving to see what’s behind you instead of looking out the front window to see where you are going.

Because it’s based on events that have already happened there is an expectation that its accurate.

If you are not completely sure how a typical tax return comes together I have a seven part series called Anatomy of a Tax Return and the first article can be accessed here.

Planning on the other hand, looking ahead to where you are going or where you want to go is a more forward-looking exercise and requires assumptions and estimates.

Financial planning is a very broad term and unfortunately there is no one single definition of what or who a financial planner is so some people claim that title and use that term very loosely.

As described above, generally speaking it’s more of a forward-looking exercise with decisions around your finances.

Your finances most certainly involve tax issues. Either its pretax money you are setting aside or its money left over after taxes have been paid in which case the less tax you pay, the more money you have left to redeploy elsewhere which is a key focus of my practice. Pay less tax, grow your wealth.

Unfortunately, most financial plans and financial advisors won’t, don’t or not allowed to talk about tax issues so in my opinion your financial plan (if you have one) is missing critical analysis, how much you pay in lifetime tax.

Taxes are one of life’s largest lifetime expenses.  That means what you pay during your working years and quite possibly during many of your retirement years.

I find that many people tend to only think taxes are if they got a refund or they owed and how much it is, but that is not the number you should be looking at first.

Total taxes are what’s owed based on your taxable income and that is somewhat controllable.  The refund you get or the additional taxes you owe is the total tax owed minus taxes paid in during the year.

If you want to pay less tax, generally you want to have less taxable income.

Most financial advisors won’t help you with that.   For those that do have a financial advisor or someone they think is their financial advisor, ask yourself when was the last time that they asked to see your tax return so they could see your tax rates and do some long-term planning?  

My guess is never.  There are a few out there but they are the minority.

If you doubt that income taxes are one of your largest lifetime expenses, take a look at your 2022 Form 1040.  Go to page 2, Line 24 Total Tax.  Take that number and multiple it by the number of years you expect to work before you retire. 

Just to see the magnitude, take that number or some smaller amount as you see fit and multiple it by the number of years you have already worked.

You can’t change the past, but you can change the future.

Many people will continue to have taxable income in their retirement years just a smaller amount than their working years.  So again for high level planning, assume half the tax of the Line 24 amount times the number of years you expect to live in retirement.

Obviously these are estimates.  Your income will change between now and retirement (hopefully upward), more income equals more tax.  Tax rates are written in pencil and will change in the future, possibly as early as 2026.

For many people that extrapolated tax amount owed is at least a small six figure amount and possibly for some a fairly large six figure amount.

If you’d rather not pay that much in tax over the rest of your life, that’s where tax planning merged with financial planning comes in.

Tax planning is more than just telling someone to maximize their IRA or 401K contributions. Its also more than just telling someone to go talk to their tax return preparer since as you learned from above, that person may do nothing more than prepare last year’s tax return with no experience or desire to look into future year tax planning.

Common financial planning advice is to minimize taxes now by taking advantage of pretax accounts and paying less tax now which is certainly a good thing.

But what if – paying less tax now caused you to pay more tax in the future?  Remember that most pretax retirement accounts are tax deferred not tax free.  So the tax that you save now lets more of your money start growing tax deferred which is a good thing.

But what if – you are in a fairly low tax bracket now, say the 15-20% bracket and retirement is many years, maybe even a couple of decades away and very likely that overall higher tax rates exist?

You could be paying taxes at a higher rate years or decades in the future on all that tax deferred growth that you got whereas maybe, just maybe, it would have made more tax sense to pay the taxes up front and be done with them and get tax free income in your retired years.

Than’s why tax and financial planning is not one size fits all and why you should not be bounced back and forth between a financial planner and a tax planner and you are left to interpret what both are telling you. 

Obviously my viewpoint is biased since I believe that your tax planner should also be able to do the financial planning and your financial planning should be done by someone capable of talking tax with you.

If you’ve decided that you’d rather pay less in tax and keep your money in your pocket and that should be part of your financial plan, use the links below to set up an initial consultation.

The information in this and other articles is intended to be educational in nature only.  Not tax, legal or investment guidance for you specifically.  Each person’s situation is unique and you must seek appropriate professional guidance that can address your unique situation.